Stocks and Bonds

Buy Bonds For A Trade. Part 2.

Summary

  • There are times bonds offer great returns.
  • There are times bonds are a poor investment.
  • There are times bonds are a superb hedge for investment portfolios.

On March 1, 2021, I published Buy Bonds For A Trade. On 2/26/2021 TLT was trading at 141.07. It bottomed on 3/18/2021 at 134.75. It has appreciated since then as yields declined.

Wall Street cannot explain why yields are declining – and bond prices rise – with massive government deficits, debt, and historically easy and inflationary monetary policy.

The trading outlook for bonds in the above article was based on this analysis.

“The time to sell TLT (iShares 20+ Years Treasury Bond ETF) took place when its price spiked with unusually heavy volume in March 2020. This pattern is a reliable indicator to sell any asset displaying it. It is a signal big sellers (strong hands) are trying to attract buyers (weak hands).

March 2020 was also the time the business cycle bottomed. Since then, TLT stopped rising, and finally began to decline in August 2020 – down about -18% as of this writing.

The change over 200 days in the price of TLT has dropped to levels associated in the past with an attractive trading opportunity – as in 2009, 2011, 2014, 2015, and 2017 … (Emphasis added).”

It was a technical call, based on the rate of change of TLT which had reached extremely low levels. The analysis discussed in March still holds, suggesting yields are more likely to decline than rise.

There are also long-term fundamental forces slowly emerging placing downward pressure on yields. The process will take a few months, but these forces will strengthen, forcing yields to keep heading even lower.

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Source: The Peter Dag Portfolio Strategy and Management

In Phase 1 of the business cycle business recognizes inventories have been cut too aggressively during the slowdown period (Phase 4). Business needs to increase inventories. This feat requires boosts in production, workers, raw materials, and capital to expand and improve the production process. The outcome is rising employment and commodities. Bond yields bottom in this phase. This is what has happened in March 2020.

In Phase 2 demand keeps strengthening as more jobs are created. Business is growing rapidly and manufacturing still tries to catch up with sales. Commodities and bond yields rise. Inflation is also raising its ugly head. This is what has been happening in 2021.

In Phase 3 demand starts to slow down as rising inflation and interest rates dampen consumers’ enthusiasm. Business does not recognize this new trend and keeps producing. Eventually inventory levels rise to levels hindering earnings. Production must be cut. Capital needs decrease. Raw materials and bond yields decline as demand wanes. Employment is also reduced because of reductions in production.

In Phase 4 business keeps cutting output to protect earnings. Eventually, however, the cut in inventories becomes excessive. Finally, business recognizes this imbalance and decides to start increasing production. And Phase 1 starts again.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

Since March 2020 business has been responding to pent-up demand by aggressively increasing production to replenish inventories. It had to increase its borrowing to finance its operations – hiring workers, purchases of raw materials, increases and improvements of productive capacity.

It is therefore no coincidence yields rise when the business cycle indicator increases. Yields decline when the business cycle indicator declines reflecting a slowdown in the demand for funds by business (see above chart). The business cycle indicator is updated in each issue of The Peter Dag Portfolio Strategy and Management. An exclusive complimentary subscription is avalable on www.peterdag.com.

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Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management.

When you throw a stone in the water the first wave is big. Then the disturbance is followed by smaller and smaller waves. Any system reacts in this way when subjected to a major shock.

The US economy is not immune to the pandemic shock which has been transmitted through the economy and financial markets.

The above chart shows the change in average weekly hours of production on a month-to-month basis. You can recognize the “waves” in the change of the weekly hours of production.

The percent change measured on a year-over-year basis shows strong growth rates mostly because changes are compared to the low bases of 2020. The month-over-month data, however, indicate what is happening in a more granular way.

Hours worked is a leading indicator of employment. Reduction of the labor force is the decision of last resort because of its associated costs. Reduction in hours worked is a less costly decision when production has to be reduced when inventories are rising too rapidly.

Since February there have been four out of five months when hours worked were reduced. The reduction in hours worked of the past five months reflects the business uneasiness with current business growth and expectations.

Slowly the economic system is heading toward its long-term growth rate. The long-term growth of the US is productivity growth average (recently 1.5%) and population growth, currently 0.4%. The sum of the two is the expected growth of the economy – close to 2%. The weakness in copper and lumber suggests the process is under way.

Another important consideration is the role of debt. I have discussed in detail this subject here. C. M. Reinhart, V. R. Reinhart, and K. S. Rogoff studied extensively the historical implications of high debt on economic growth in many countries over centuries. Their conclusions apply perfectly to what is happening now.

The implication of their wide-ranging studies suggests growth will remain depressed as the economy is strangled by the transfer of wealth from interest payers to the bond holders, further enhancing income differential.

The fundamental direction of the economy is to slowly reach growth of about 2%. More money is printed, and more adverse results are achieved. It will be proved what history has shown extensively throughout the centuries – printing money without increases in productivity growth causes stagnation.

Let’s see how the equity and bond markets are reacting to this news.

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Source: The Peter Dag Portfolio Strategy and Management

The above chart shows the ratio of SPY (SPDR S&P 500 ETF Trust) divided by TLT (iShares 20+ Year Treasury Bond ETF) in the upper panel. The total returns of SPY are greater than those of TLT when the ratio rises. During such times it pays to be invested in SPY rather than TLT.

SPY outperformed TLT from 2004 to 2007, from 2009 to 2011, from 2012 to 2014, and from 2016 to 2018.

However, the total returns of TLT outperform that of SPY when the ratio declines. TLT outperformed SPY from 2007 to 2009, from 2011 to 2012, from 2014 to 2016, and from 2018 to 2020.

The interesting part of these statistics is TLT has outperformed SPY for about two years when our strategic indicator (lower panel) declines, reflecting a slowdown in business activity. The strategic indicator is updated regularly in The Peter Dag Portfolio Strategy and Management on www.peterdag.com.

During such times portfolios should be mostly invested in TLT for two reasons. The first one is TLT offers greater returns than SPY. The second reason is TLT provides an excellent hedge by reducing portfolio’s volatility when the business cycle declines.

Please note, this relation does not say bonds always outperform stocks. It simply says the total return of TLT outperforms the total return of SPY when the strategic indicator declines.

The indicator in the lower panel suggests we have entered a period when TLT will continue to outperform SPY as it has been doing since May 2021.

Key takeaways

  • The long-term growth potential of the economy is close to 1.5%-2.0% (productivity plus employment growth).
  • The economy through successive “waves” will irregularly slow down to these levels.
  • The business cycle is close to a peak, a process likely to take place over the next several months.
  • TLT has been outperforming SPY since May 2021.
  • The strategic indicator suggests the market has entered a period when TLT will continue to outperform SPY.
  • When the strategic indicator declines, TLT is a hedge against market weakness. It decreases the volatility of an investment portfolio and makes its performance more predictable.
  • SPY outperforms TLT when the strategic indicator rises, and the business cycle is in Phase 1 & Phase 2.